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News September 25, 2006 Issue

Donohue Describes Plans to Streamline ETF Approvals

Look for the SEC to speed up the processing of routine index-based ETF exemptive applications. And down the line, we might even see an ETF rule codifying routine relief.

So said Division of Investment Management director Andrew "Buddy" Donohue last week, during remarks at an ETF-oriented conference.

Donohue began by speaking highly of the Division’s staff, calling them "intelligent and dedicated." However, he acknowledged the industry’s complaints about delays in obtaining ETF relief. Upon joining the Division, he was told that "many people" felt that the SEC and the Division were "moving too slowly" in reviewing new ETFs.

Hmmm … might he have been talking to former Division director Barry Barbash? In recent months, Barbash has been openly critical of the ETF application process. Speaking at an American Enterprise Institute seminar in February 2006, Barbash noted that the first ETFs "took a justifiably long period of time because there were a lot of issues that needed to be worked through." However, he added, "it’s almost 13 years after, and the degree of analysis that is done by the staff on an ETF oftentimes is exactly the same." ETF approvals, said Barbash, "can take two or three years."

In any event, Donohue said that when he came on board, it "seemed obvious" that the Division needed to take a closer look at the ETF application process.

And so, it did.

"I am pleased to report that we are currently in the midst of a concerted effort to evaluate and improve our process for reviewing ETF proposals," said Donohue. "My staff and I, as well as Chairman [Christopher] Cox and the other Commissioners, are committed to ensuring that proposals to introduce ETFs are reviewed and considered in an efficient manner with an appropriate level of staff analysis."

To that end, Donohue announced four initiatives:

Fast-tracking of routine index-based ETF applications. Donohue noted that the Division’s exemptive office currently faces a "significant" number of pending ETF applications. "[E]ven though we’ve been issuing ETF orders at a record pace in the past few months, we’ve also received a record number of ETF proposals," he said. To speed things up, the staff is prioritizing the review of routine index-based ETF applications as "time sensitive," he said. "I expect that you will see additional tangible results in the coming months, as more orders for routine ETF applications are issued."

Reducing scrutiny of underlying indices. Donohue said that the staff may change its review process by reducing the current time-consuming scrutiny of indices. The Division staff, said Donohue, is "considering the merits" of de-emphasizing the staff’s focus on the securities indices underlying ETFs. "Part of the staff’s typical analysis of ETF exemptive applications has been to examine the pricing, liquidity, and other characteristics of the securities in an index underlying an ETF," he explained. "As the staff has monitored developments and operations in the ETF marketplace, it appears that the basic ETF structure has functioned as designed for index-based ETFs, notwithstanding differences in the characteristics of index securities." Based on that experience, he said, the staff is considering streamlining its comment process for applications proposing ETF operations that are "similar or identical" to those normally described for index-based ETFs. The staff’s review would focus on ensuring structural consistency among products, while reducing the scrutiny of underlying securities markets.

Prospective relief for ETF sponsors. Donohue said that the staff may issue ETF orders that apply to the specific ETF and any future, similar ETFs offered by the same sponsor. This would allow ETF groups to introduce similar ETFs without going through the exemptive applications process a second time, resulting in fewer applications from the same groups.

An ETF rule codifying routine orders. Donohue said that the staff "is beginning to develop a proposal for an ETF rule." This, he said, is the "most significant" ETF initiative. The new Investment Company Act rule would allow ETFs to come to market without first obtaining an exemptive order. "As the staff envisions such a rule, it would need to be appropriately tailored to those types of ETFs with which we have substantial experience, most likely routine index-based ETFs," said Donohue. "[T]he number of new routine index-based ETF applications submitted this year has convinced us that there is value in focusing our limited resources on developing a proposal for an ETF exemptive rule."

Donohue indicated that the four initiatives would be applicable only to routine ETFs. Novel ETF applications, such as affiliated index ETFs, leveraged ETFs, and the still-pending actively-managed ETFs, would continue to be subject to traditional reviews. Approval of ETF innovations, he said, "must be taken with thoughtful consideration and responsible review of the potential implications for investors and the marketplace." Streamlining the review process for standard ETF applications, will allow the staff to target its "energy, effort, and expertise" on novel proposals, he said.

Speaking of actively-managed ETFs, why hasn’t the SEC approved any?

One of the stickiest issues in connection with actively-managed ETFs is transparency, said Donohue. On one hand, he noted that transparency of portfolios is a "hallmark" of ETFs and has led to efficient trading in ETF shares. On the other hand, he noted that too much transparency can telegraph a portfolio manager’s moves to the marketplace, hurting a fund’s performance. "In the context of proposals for actively-managed ETFs, we likely will be called upon to assess the extent to which transparency is critical to the ETF structure, and to make recommendations to the Commission as to how this issue should be addressed," he said.

Lastly, Donohue announced two steps designed to improve communications between the Division’s exemptive application office and the industry. For all types of applications (ETF or otherwise), applicants will be provided with the name and phone number of an SEC staff person whom they can call to find out what is going on with their application. Moreover, they will receive periodic updates about the status of the staff’s review of their applications. "Applicants deserve to know the status of their applications and to have a point of contact to find out information about the staff’s review," said Donohue. He also encouraged firms with multiple pending applications to inform the staff if one of them has business priority.

Donohue noted that prior to joining the SEC last spring, he had spent over 30 years "on the outside of the SEC looking in." Now that he’s finally gotten a "look behind the curtain," as he put it, "one can make some interesting observations." Happily, he reported that the staff is dedicated to moving along ETF applications. "These applications do not fall into a black hole — where some on the outside may perceive them to be. The staff is raising relevant issues internally, coordinating with each other to ensure consistency, and conducting research to understand the legal and marketplace ramifications of the requested relief." These internal processes, he noted, may not be visible to those on the outside.

Donohue also touched on another major Division initiative: A wholesale review of the investment company disclosure regime. During his remarks, he solicited views on whether "product descriptions," used in the ETF context, might be helpful to investors. He also asked whether the SEC should utilize such a disclosure requirement for other products "purchased in the secondary, or even primary, market." (A "primary market," explained an SEC spokesperson, is a market where an investor purchases an investment product directly from the issuer, such as in the case of IPOs and direct-sold mutual funds.)

At the conclusion of his remarks, Donohue emphasized that he did not want his staff or the Division to be an unnecessary impediment to new product development or innovation. "I think we all can agree that investors generally benefit from responsible product innovations," he said. "I am committed to improving the ETF approval process, and Chairman Cox has identified the efficient processing of ETF applications as one of his priorities." The issue, he added, "is receiving focus from the most senior levels at the SEC."